Tuesday, August 30, 2005

The Oil-centric Universe
In the time of Copernicus, the purveyors of conventional wisdom had to invent increasingly complex and esoteric mechanisms to contradict the growing evidence that the earth and planets revolve around the sun, and not vice versa. I've just read a fascinating article disputing one company's assessment of a trend of declining oil demand increases, over time. While the trend attributed to BP fails to explain the experience of the last couple of years, the author's rebuttal depends on seeing oil prices as the fulcrum of the entire global economy, much as Copernicus's foes saw the solar system. Even at a time of high and rising oil prices, it is vital to retain perspective and see oil as one component--albeit a strategic one--among many in a complex global system.

The article highlights two common fallacies about oil and oil prices. First, there's a tendency to see oil prices as the horse to the economy's cart. This forces the author to invent a bizarre "reverse elastic function" to explain how oil demand can continue rising in the face of increasing oil prices. One of the comments posted with the article provides a simpler, more obvious explanation: economic growth has been shifting the oil demand curve steadily to the right. We are experiencing a demand-driven market, in rapidly industrializing economies like China, and in mature countries with increasing wealth, such as the US. In other words, demand for oil grows as the demand for the things you can do with it expands, (e.g., driving to meetings, flying to vacations, or making plastic widgets) and as its price relative to other goods (e.g., food, entertainment, and health care) falls. This can then lead to higher oil prices. The same effect is at work in many other commodities, such as steel. But a supply-constrained market would not behave this way, particularly if the constraint were the result of something like Peak Oil.

Secondly, it's easy to forget the long lead times for the investments required to reduce energy intensity, and to conclude from this that oil demand is inelastic (or somehow inversely elastic.) Look at the experience of the last oil shocks. After dipping slightly following the embargo, oil demand resumed its upward trend. Then, several years later, coinciding with the rapid energy price rises of the 1979 Iranian Revolution, the impact of lower economic growth, massive energy conservation investment, and fuel-switching kicked in with a vengeance, reducing not just the rate of growth of oil demand, but cutting absolute oil consumption by millions of barrels per day per year for several years. The longer oil prices remain at current or higher levels, the more of this kind of investment we will see, particularly where the scope for it is largest, and the economic return associated with it greatest, as in China.

There is no good way to predict whether or when oil demand growth will slow or turn negative, or if oil supply will stall or rise rapidly enough to outstrip demand in the years ahead, though there's been at least one indicator of the latter recently. The uncertainties involved include the same uncertainties underlying the health of the global and national economy. But we needn't rely on counter-intuitive and counter-theoretical explanations for things we can see in the real world, when there are simpler explanations available.

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